The power market design column – State of the power market

What is the state of the power market since the state of the union? On 14 September 2022 Ursula von der Leyen, president of the European Commission presented the?State of the Union?to the members of the EU parliament. A special day for power market design aficionados as she not only presented emergency measures to intervene in the power market but she also mentioned that a deep and comprehensive reform of the market design is needed. I have been actively involved in the establishment of that EU power market since 30 years, but now we have reached a new era.

(This column is based on an article that has been published in Energeia.)

I was first confronted with a liberalized power market in 1990. A colleague presented the electricity pool that was introduced in England and Wales. My first response was that this is nonsense as one could never trade electricity and detangle reactive power – needed for voltage control - from active power. Well, I was wrong. Commercial activities were unbundled from regulated “wires business”. Grid codes were developed that governed the interface between the system operators and the system users.?And the market developed.

Two years later in 1992, I joined a newly created European Affairs department and since then I am working in the field of electricity market rules. My colleague at that time, Pieter van Reeuwijk not only learned me the word?foisonnement, but also presented me the dynamics of EU developments. He explained that the EU Commission is like an oil tanker. It has one goal, the creation of a single market with free movement of goods, and it cannot easily change its direction on its course to that goal. And indeed, step by step new?legislation?was proposed and implemented. It already started with the transit directive of 1990, but the real start was the 1st?package of legislation adopted in 1996, the 2nd?package opened the market for all consumers and the 3rd?package established the EU institutions ENTSO-E and ACER. Then we had the 4th?package, or clean energy package, that did not add much to the power market design. But one of the things this package did, was that it confirmed the importance of free formation of prices and abolishment of price caps. The Commission opposed introduction of capacity markets and under the new rules such mechanisms are only allowed for a limited period of time. By consequence, it was important to underline that scarcity prices must be able to be formed as otherwise generators would not be able to fully recover fixed costs.

Will the market function without intervention or will there be interventions in the market in order to keep prices down?

This question, whether the so-called energy-only-market could work or whether an additional capacity market is needed to reward production resources for their availability, even if they are not actually deployed, has been debated since liberalization started. The key point in that debate was whether society and politicians would accept high prices in times of scarcity or whether they would intervene. If no action is taken, and more importantly, if investors trust that there would be no interventions, the energy-only-market model can theoretically function well. The discussion remained undecided all these years. No one had experienced a brownout because of an actual shortage of production capacity, and hopefully we never would. Those who could best look through the crystal bowl could speak up.

But now the debate has become real. Electricity prices are high, very high, and it is not just a few spikes during some days. The EU is confronted with record high prices that will remain for quite some time. The first quarter of 2023, base-load for the Netherlands trades above 500 Euro/MWh. Calendar year 2025 trades around 170 Euro/MWh. Much lower, but still at levels that we did not see for decades.?

And the answer has been given. The high prices are too hard to bear. Vulnerable consumers, households and enterprises, have to be compensated. But more importantly the EU has decided that this should, at least partially, be financed from a wind-fall tax levied at generators. The argument is that generators with inframarginal technologies would make extraordinary profits. Inframarginal technologies are generation plants with low variable costs (like wind, PV and nuclear). The price is set by the plant with the highest variable cost that is needed to meet system demand. The so-called marginal pricing principle. The marginal plant is often a gas-fired plant, and because of the extremely high gas price also the electricity price is set extremely high. The result is that all the plants with lower variable costs make huge inframarginal rents.

The story seems obvious. The high gas price is the result of Russia cutting gas supply as part of its war strategy. Excess profits collected by some producers are absurdly high and must be skimmed off to compensate consumers for sky-high energy bills. But let’s have a closer look.

There is no EU market model and therefore it is not possible to intervene in the market model

Much attention is paid to the day-ahead market, which is organized by the power exchanges and which is coupled within the EU. A market clearing price applies to that market segment. All buyers who bid above that price pay that price and all sellers who offer below that price receive that price. At the same time, there are many other market segments in which electricity is traded for different periods and with different products. Moreover, day-ahead trading via the power exchanges is not mandatory. Not all production is traded via the power exchange. And a producer can also be active as a buyer on the exchange, for example if he has already sold his production on the forward market. It may seem complicated, but the good news is that all this doesn’t matter. The EU power market is organized in a decentralized manner and pricing is free. Buyers and sellers mutually determine the price. There is no prescribed market model, so it is not possible to intervene in a market model.

Of course, the organized day-ahead market of the power exchanges can be tweaked, but because this is not a mandatory market, it will not have a significant impact on the price overall. For example, a price cap can be imposed on day-ahead trading via the power exchanges. But if there are buyers who still want to buy above that cap, they can go elsewhere and there will of course always be sellers who are happy to deliver for a higher price.

Electricity is a homogeneous good. The same stuff can be supplied by a wind turbine or by a coal-fired power plant. Electricity has an equal price within each bidding zone, at least at some point for a given delivery period. For example, if you are reading this, the product baseload for the year 2023 is being traded and all buyers and sellers in the market are dealing with the same price. But an hour later, that price for the same product may have changed again.

Basically, the price is determined by the amount of supply and demand. The market model, i.e. the way in which supply and demand are brought together, does not determine the price level.

The merit order works great on paper or in the computer

The concept of merit-order or merit-order curve cropped up frequently in recent discussions and was also mentioned by Von der Leyen in the State of the Union. The merit order lists the various available means of production in order of increasing variable costs. Wind and solar are on the far left with zero variable production costs and gas-fired electricity production is currently on the far right in the merit order due to the high gas price. Subsequently, the variable costs of the most expensive production resource needed to meet demand determines the electricity price.

It should be clear from the previous paragraphs that there is no single price and that there is no marketplace where all producers act as sellers. The merit order can therefore not be found on any marketplace. But the merit order is extremely suitable for calculating the level of the electricity price on a sheet of paper or with a computer simulation.

The merit order is constantly changing; static and dynamic optimization

It is important to note that a merit order can only be drawn for one particular moment in time. It is??constantly changing over time. Not only are investments made in new production capacity or existing capacity is closed, but investments can also be made in life time extension. Or the minimum capacity on which stable generation is possible can be reduced in order to operate more flexibly. The availability of production resources also varies. Maintenance periods can be adjusted, fuel stocks are managed. This dynamic is essential. Market forces not only ensure that the most efficient means of production are used to meet demand at a given moment. That is the static economic dispatch. But prices also determine decisions about investments and operational choices. So market forces also determine which assets are available. Here, too, market forces lead to optimization and thus welfare gains.

Market forces do not cause high prices but bring welfare, even at high prices

Recently we have seen several cases where industry is closing activities like the aluminum plant in the Netherlands that has been shut down by Aldel. These decisions are painful. But the added value of aluminum production is apparently lower than many other forms of electricity consumption. There is no good alternative to market functioning. Rationing is possible, but then economic activities that are more valuable are affected and society is even worse off.?

Market forces are not causing high prices. High prices are the result of high demand and low supply. So it makes no sense to intervene in market functioning in an attempt to lower prices. But it also backfires. After all, market forces lead to welfare gains. Market forces lead to optimal use of production resources, demand response and storage. And market forces lead to an optimal mix of various technologies being available. This added value is also realized when prices are extremely high. Intervening in the market therefore means that consumers will ultimately pay even more for energy.

A price cap for inframarginal rents: counter-productive

Let’s have a closer look at the ceiling for infra-marginal rents. The idea is to reduce the impact of the pricing setting marginal plant on the revenues of producers with lower variable costs. It therefore concerns all technologies that are on the left side of the merit order. Assuming that a gas-fired power plant is the marginal unit, the inframarginal technologies are solar and wind, hydropower, nuclear, oil and coal plants. It is true that these technologies benefit from the high electricity price caused by the high gas price. The difference between the variable costs of these plants and the market price is called the inframarginal rent. So, it is income, but not profit. After all, these technologies normally have higher fixed costs. High inframarginal rent is a signal for the market to increase the availability of these technologies, through investments or through other ways. Skimming this income therefore disrupts the steering effect of the market. The availability of inframarginal plants will be negatively affected and as a result more gas-fired generation will be needed. Power prices will go up. Costs for consumers will increase and the measure is thus counterproductive.?

A price cap for inframarginal rents: unjustified

Proponents of the cap may understand that it has a distortive effect, but they say that electricity prices and thus inframarginal rents are extraordinary high. There is a war, Russia is reducing gas flows as part of their war strategy, the prices are not realistic and thus have lost their importance to steer behavior of the market. Moreover, it would be windfall profits that these companies would never have counted on and would thus not be entitled to.

However, that reasoning is incorrect. If after the war the gas were to flow out of Russia again, the infra-marginal revenues would fall again rapidly and then investments based on high infra-marginal revenues would indeed backfire. But that scenario doesn't apply. The EU wants to get rid of Russian gas anyway. And so, the steering effect of current prices and inframarginal rents is perfectly in order.

The question remains whether the current high rents for some technologies are excessive and may therefore be skimmed. Opinions will remain divided on this. But actually 50 years ago the Club of Rome predicted that the current scenario will one day happen. So yes, there are companies that are making big profits right now, and no, that's not the same as winning the top prize in a lottery that you didn't know you were participating in.

The comparison has been made to profits made by supermarkets during the Covid19 pandemic. Restaurants were forced to close by decision of the government and therefore supermarkets were benefitting and making high profits. Still no windfall profit tax was introduced for supermarkets, at least not in the Netherlands. Such a tax on supermarkets would however make more sense than a tax on electricity producers. The first difference is that the closure of restaurants was temporary whereas the long-term objective is to get rid of Russian gas. Secondly, one can argue that a supermarket has never invested with the idea that restaurants could be closed for months. Whereas investors in renewables did take the possibility into account that fossil fuels would become scarce.

A price cap for inframarginal rents: unfeasible and unfair

The idea to cap inframarginal rents has already been elaborated in a proposed EU regulation. The cap should apply to producers and should skim the income from inframarginal technologies above 180 Euro/MWh.?The idea seems simple, but it is not.?

The main problem is how to determine the actual income that a producer obtained with its inframarginal plants. It may have sold its output in forward or long-term contracts at a much lower price than current prices. In that case the producer has no profits at all, but its counterpart (the PPA-offtaker or the consumer) is making profits.??Secondly, a producer is not selling its output through one transaction, there may be many transactions on the forward, day-ahead and intraday markets. And finally, remaining imbalances are settled against the imbalance price. Thirdly, these transactions are normally done for a portfolio of assets and contractual obligations. In that case it is impossible to link a transaction to a certain plant. Fourth, there is auto-production by prosumers. In that case there is no explicit transaction, but the prosumer benefits by avoiding paying the high retail price.?

It is obvious that correct implementation of the cap is a nightmare, or better put, impossible. One could opt for a more basic implementation, but then the outcome would not be fair, as companies without profits are taxed and other companies with possibly, huge profits, remain untouched.

A price cap for inframarginal rents: unnecessary

The problem is simple. Europe is a net importer of energy and Europe is getting poorer because of the extremely high energy prices. This cannot be prevented by dividing the cake in a different way. There is no other option than to do what always has to be done: work hard, work efficiently, work smart and collaborate. Now we need to find political leaders who dare to deliver this message. Subsequently, vulnerable consumers (households and enterprises) must be supported, whereby the strongest shoulders bear the heaviest burden. If necessary, taxes must be increased. Corporate taxes and wealth tax can be used. The effect of a higher profit tax is comparable to a price cap on infra-marginal income, but it is much easier to implement, it is fairer, and the distortive effect is smaller.?

Any tax is distortive and changes the behavior of actors in the market. But tax theory says that to minimize this distortive effect, taxes must be placed low in the value chain. The cap on inframarginal rents, which is a tax on inframarginal rents, is placed high in the value chain. It is therefore a textbook example of an ill-designed tax.??

A price cap for inframarginal rents: a blow for the investment climate

As the proposed cap is an unjustified and ill-designed measure, it also worsens the investment climate. It reduces the financing power of companies that are needed to make the energy transition work and it reduces trust of investors in the stability of the market.?

Then what? Confirm solidarity rules

Of course, the current energy crisis requires action.??The best approach is to facilitate more supply and less consumption. The price signals are clear, but if there are still barriers for producers or consumers to respond, they must be removed. Everyone agrees on that, so what else could be done at European level?

One aspect that needs attention is mutual solidarity between countries when things get really tight and load shedding might become necessary. In that case, a Member State may be tempted to stop exporting to neighboring countries in order to protect supply to its own citizens. It is a measure that has already been mentioned by Norway and France.

In fact, such actions are prohibited, especially if they are done in response to high prices. But when a country claims it is an emergency measure as a last resort to avoid total chaos, things become less clear. Even then, the logic of the market offers a solution. If Norway exports to the Netherlands, electricity in the Netherlands has more value or the Netherlands is closer to a brownout than Norway, assuming that both countries have a comparable value of lost load (VoLL). In short, restricting exports hurts the importing country more than it benefits the exporting country.

It would be good if the Member States would reaffirm and, where necessary, clarify the solidarity rules.

Then what? Harmonize emergency market rules

There is still more work to be done when it comes to market rules in times of emergency. Based on the European network code on electricity emergency and restoration, the Member States have their own rules for suspending and resuming market activities. In the Netherlands, TenneT rightly applies the principle that suspending the market is never useful, but other countries see it differently. This lack of harmonization is not acceptable. It is especially necessary in critical situations that clear rules are in place. It is, after all, a single internal market. It is unimaginable how things can go well when one country suspends a market activity and a neighboring country does not. ACER already?asked?the national grid operators last year to start working on this much-needed harmonisation. The current market situation makes such an action urgent.

Then what? A European energy policy from a geopolitical perspective

The European electricity and gas market is under extreme stress. Not only vulnerable consumers need support, also some energy companies need credit support because of extremely high margin calls. And the requirement to fill gas storage was already a market intervention that did increase gas prices. Still even in the current situation with extremely high prices, price formation is correct. The market still offers great advantages. And, very important, what alternative could do better? Yet the current crisis also shows what the limits of that European market are, namely the borders of the EU itself. The gas market is largely a global market, where developments in Asia and America also determine prices in the EU. And if there is a dominant supplier (read Gazprom) that is located outside the EU, European competition rules do not help.

There is therefore a need for European energy policy. The idea of joint procurement was already on the agenda at the July meeting of the Council of Ministers. And actually, it was Poland, through Donald Tusk, then the Polish Prime Minister, who already sounded the alarm bell in 2014. He launched the idea of an Energy Union out of concerns about security of supply due to the tensions between Russia and Ukraine. Tusk was subsequently elected president of the EU and so the concept of the Energy Union also became a priority for Juncker, then President of the European Commission. But the original idea of the Energy Union was skillfully dismantled by Juncker, probably because the idea of joint energy procurement at EU level would not be compatible with the internal market. Ultimately, a large legislative package, the clean energy package, was adopted that excels in superfluous legislation and regulations.

Anyway, new times, new opportunities. The original Polish proposal for an Energy Union can be again brought to the table. This should certainly not only deal with joint procurement of energy. That is probably not realistic. But one could also think of European strategic reserves with European rules for filling and utilization. Member States are traditionally wary of transferring powers to “Brussels”. But this discussion really needs to be taken seriously.

In conclusion; is the oil tanker heading for a new destiny?

The European electricity market is undergoing a stress test. After 20 years of theoretical discussions about whether government will intervene in the face of high prices and impending brownouts, the moment of truth has arrived. The decision to intervene in the market, skimming inframarginal rents for the support of vulnerable consumers, can be seen as historic event. Since the creation of the European Economic Community in 1957, the Commission has been working to create an internal market with the free movement of goods. It took some time for civil servants in Brussels to realize that energy was also a good, but then, more than 20 years ago, the gas and electricity markets were liberalized as well. Subsequently, the liberalization of those markets was further developed step by step with various legislative packages.

It is no coincidence that a new course can be seen now. The Commission started in 2019, and in the von der Leyen’s Mission Letter to Kadri Simson, the Commissioner for Energy, the word “market” is difficult to find. The focus shifted to climate policy with more attention to social aspects. Also, in the State of the Union, von der Leyen speaks about a “social market economy”. Apparently, profits are still good, but extraordinary profits are not. Von der Leyen said that those record high profits are made on the back of consumers. Such a statement is not in line with the laws of economics. It can even be labelled as dangerous as it fuels populistic forces that claim that the European internal market is causing consumers to suffer.?

The statement is also regrettable because it's not a matter of either-or. Good climate policy with and social policy with attention to the more vulnerable members of society can very well be reconciled with market forces. Market forces are not an end, but a means and there are limits to where market forces can be used. But unfounded interventions in the market do not bring the achievement of the climate goals any closer, nor do they mean that energy poverty can be combated better.

The interventions that should rationally be rejected, may still be understandable as temporary emergency measures with a view to the extreme energy prices and the war that is taking place just across the borders of the EU. But von der Leyen made it clear that it is not just about temporary interventions. She said that a deep and comprehensive reform of the power market design is needed and that the current market design – based on merit order – is not doing justice to consumers anymore. A statement that makes economists shudder. The market outcome and not the market design is based on merit order, and that market outcome is bringing welfare to consumers.?

The oil tanker changed its course. But the new destiny is not fully clear yet. Let’s hope that the European Commission and the Council of Ministers do not jump to conclusions and let’s hope that there will be proper debate first on the need of such reform.?

#SOTEU2022 #powermarketdesign

This is my 34rd column on power market design issues. The earlier columns covered the following topics:review of the CACM Regulation,?market myths and price formation,?system support balancing,?Blackouts,?the importance of ACER,?Flexibility and foisonnement,?reliability and load shedding,?regulation of congestion income,?dynamic network tariffs,?energy communities,?scarcity pricing,?the Florence Forum,?active system management,?network planning & sector coupling,?off-shore assets,?intraday capacity hoarding and pricing,?interconnectors,?international comparison of market designs,?cross-border capacity calculation,?flexibility,?cross-border capacity,?electric time and unintended exchanges,?EU Network Codes,?price formation and zero marginal cost generation,?simplicity in the Clean Energy Package,?smart grids,?storage,?auto-generation,?balancing,?VoLL,?demand side response,?interconnectors?and the?Economist on market design.

Disclaimer: The views as expressed in this column do not necessarily reflect the views of Energie-Nederland

Paul Giesbertz

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